Will bears have the last laugh?

Commentary: Dow's gain likely to be just another fakeout

NEW YORK (MarketWatch) -- The only thing more frustrating than buying the high of a breakout, or selling at the low of a correction, is to keep doing it over and over.

False breakouts may be the most irritating market patterns, because they do two things: They keep you from being aggressive on the next breakout/breakdown, which could cost you a lot of opportunity; and it can make you question all the other signals that you've become accustomed to following.

While you can expect some sort of correction after a strong move, enough to make you question your resolve, but they are usually contained within predetermined support or resistance zones, at least on a closing basis.

The Dow industrials
DJIA, +0.89%
followed November's apparent upside breakout with an apparent breakdown in late December.

If that wasn't enough, the mid-January breakout above 11,000 proved to be a head fake, and the Dow broke down yet again, closing last Friday at a 2-month low.

Now, after running up about 200 points since Thursday, it seems the Dow appears headed for another run to the upside, and bears appear to have been fooled yet again.

There are some signs that suggest, however, that it may be the bears who will have the last laugh.

Expanding triangle

The Dow may be producing false breakouts and breakdowns when looking at the chart in a two dimensional way (just up and down), but a three dimensional view (up, down and sideways) shows that it has been trading within a range referred to as a broadening, or expanding triangle.

The top of the range has been a rising trendline connecting the late-November and early-January highs. If the Dow's rally continues, it could climb up to 11,080 to extend this line.

Meanwhile, the bottom has been tracing out a downtrend line connecting the lows of early-December and early- and late-January. An extension of this line currently comes in at around 10,630.

This pattern indicates that market forces are getting impatient and uncertain at a time when fundamentals can be interpreted as mixed. With economic growth slowing, crude still rising, and a choppy corporate profit outlook, perhaps the market appears to be getting a bit too volatile for those looking for a more steady return.

You can see this via the chart of the market's so-called "fear gauge" the CBOE Volatility Index
$VIX
It spiked up 2 1/2-month high of 14.56 on Jan. 20 before pulling back.

The breakout in volatility hasn't been negated yet, as it has fallen back to support just above the gap in the charts between the Jan. 13 high of 11.61 and the Jan. 17 low of 11.87.

In addition, the gap appeared right after the creation of an inverted head-and-shoulders reversal pattern, with the mid-November and early-January lows the top of the upside down shoulders, and the mid-December low the top of the head. Read more about head-and-shoulders patterns.

This suggests support should be rather strong, and that the fear gauge is likely on the verge of starting another rally. It traded up 2.2% to $12.23 in midday trading on Monday, despite gains in the major stock market indexes.

When investors are uncertain -- and more so when they are afraid -- they tend to close out positions.

Therefore, expanding triangles tend to be resolved in the opposite direction of the trend that preceded them.

While the blue chip barometer has been making higher highs along with its lower lows, some of the oscillators have been consistently making lower highs and lower lows.

For instance, the relative strength index (RSI), which relates the strength of up days to down days, made a high of 75.16 in late-November and a high of 68.50 in early-January, while the Dow's highs increased from 10,959 to 11,047.

The momentum indicator, a study of the rate of change relative to prior movement, reached a high of 444.80 in mid-November, and a high of 206.30 in early-January.

(Note that different charting packages may have different prices for RSI or momentum depending on what daily price point they use to calculate them, but the general trend should be the same.)

This pattern is recognized as "negative divergence," and is believed to be a sign of underlying weakness. See interactive java chart.

While these developments are not always good market timing tools -- markets could be in negative divergence for months, and even years -- they can at least point you in the right direction, especially during times of range trading, so when the real move does come, you are ready for it.

While an expanding triangle and negative divergence may not be a definitive signal for a downside reversal, the combination of the two indicators is worth noting.

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